The Great Depression1929-1933

The Defining Moment

Why “Great” DepressionBen Bernanke: “To understand the Great Depression is the Holy Grail of macroeconomics. Not only did the Depression give birth to macroeconomics as a distinct field of study, but also---to an extent that is not always fully appreciated—the experience of the 1930s continues to influence macroeconomists; beliefs, policy recommendations and research agendas…..We do not yet have our hands on the Grail by any means…..”(JMCB, 1995)

Rex Tugwell (advisor to Roosevelt)

“The Cat is out of the Bag. There is no invisible hand.

There never was. If the depression has not taught us

that we are incapable of education…..We must now

supply a real and visible guiding hand to do the task

which that mythical, nonexistent, invisible agency

was supposed to perform, but never did.”

The Prelude 1919-1929 • U.S. enters the war late. (1917-1918)

effects on U.S. economy relatively small compared to European economies.

• Huge damage and disruption to European economies.

• Real GDP = 100 in 1913. In 1919, UK=101 France=75 Germany=72 US = 116

• Inflation! Price level = 100 in 1914. In 1918 UK=210 France=213 Germany304 US=164

• Huge climb in Debt/GDP ratios.

Consequences1. World War I---9.5 million deaths. Loss of a

generation (UK 1m, France 1.4m, Germany 2m, US 114,000)

2. Destruction of physical capital especially Belgium and northern France

3. Distortion of patterns of production, trade and consumption (e.g. high wartime prices for commodities—boom and collapse in U.S.

4. High cost of war. Estimated $208 billion.5. Political and economic borders of Europe are

redrawn.6. Inter-allied war debts and German reparations.

Inter-Allied War Debts ($ billions) (Kindleberger,The World in Depression

United States United Kingdom

France

Other Countries

4.0

4.7

3.2

3.0

8.1

3.5

To pay principal and interest, war devastated economies would have to run balance of payments surpluses.

German Reparations• John Maynard Keynes (1919) Reparations

were a “policy of reducing Germany to servitude for a generation, of degrading the lives of millions of human beings, and of depriving a whole nation of happiness.” They were “abhorrent and detestable.”

• Étienne Mantoux (1946) Reparations not excessive, destructive or uncollectible.

• The French paid in 1815 and 1871---”Le Boche Paiera”

The magnitude of reparationsIndemnity (billions)

Percent of One Year's GDP

Share of Debt

Service to GDP

France 1815-1819 FF 1.65 to 1.95

18 to 21 1.2 to 1.4

France 1871 FF 5.0 25 0.7Germany1923-1931 DM 50 83 2.5Vichy 1940-44Germany1953-1965Japan 1955-1965

FF 479527 US$1486 US$

1117.73.0

2.60.40.8

Solution---the Dawes Loan 1924

• German Hyperinflation.• Dawes Loan---begins series of loans---

U.S. provides funds and funds for investment around the globe.

• New York as central of global finance—not London

Return to Gold Standard“Status Quo Antebellum”

• No problem for U.S.—huge balance of payments surpluses and gold

• U.K. deflates and returns to gold in 1925 at old parity £1 = $4.86. But overvalued. Depressed economy.

• France with near hyperinflation returns to gold in 1926 at a new parity (old $1= 5FF now $1 = 25.5 FF) Undervalued currency. Booming economy.

• Germany’s hyperinflation---returns to gold at near purchasing power 1925.

• Major imbalances---brittle equilibrium.

Adjustment under restored gold standard more difficult

• International capital markets are revived---generally free.

• International labor flows almost eliminated—immigration restrictions

• Increased protectionism• Less wage flexibility. Wage now seem

sticky even with high unemployment

U.S. Economic Prosperity in 1920s• No trend inflation• High productivity growth• 1922-1929, GNP grew at 4.7%, • Unemployment averaged 3.7%. • Fed accommodated seasonal demands for

credit and attempted to smooth economic fluctuations. (2 brief recessions)

Some basic numbers• Peak August 1929, Trough May 1933• Real GDP falls 39%• Real Consumption falls 29%• Prices (GDP deflator) falls 23%• Unemployment Jumps:

– 3.2% in 1929 – 25% in 1933 (21%Darby) – 17% in 1939 (17% Darby)

• Banking Collapse– July 1929, 24,504 banks, $49 billion deposits. – December 1932, 17,802 banks, with $36 billion. – After Bank Holiday March 1933, 11,878 banks with

$23 billion deposits.

Key American Role in World Depression• Based on

industrial production GD starts in most countries at the same time

• But it is larger and longer in the U.S. Romer (1993)

Worst in the U.S.• For the U.S.,

Industrial Production– Biggest drop in

first year– Biggest drop

peak to trough– Biggest drop in

the last year.• However, turning

points are very similar

Understanding the Great Depression: Its Evolution by Phases

1. Booming Strong Economy in 1920s2. Beginning Shocks, 1928-19293. Aggravating Shocks, 1930-19334. Rock Bottom and Recovery, 1933-19365. The 1937-1938 Recession6. The Recovery, 1939-1941

Real GDP, 1920-1941

60

70

80

90

100

110

120

130

140

1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941

1929

=100

Understanding the Great Depression:

Four Basic Questions1. Why it Began?2. Why so Deep?3. Duration?4. Recovery?

Real GDP, 1920-1941

60

70

80

90

100

110

120

130

140

1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941

1929

=100

Understanding the Great Depression: Its Evolution by Phases

1. Booming Strong Economy in 1920s…buta) It’s the Roaring Twenties!b) No trend inflationc) High productivity growthd) 1922-1929, GNP grew at 4.7%, e) Unemployment averaged 3.7%.f) Fed accommodated seasonal demands for credit and

attempted to smooth economic fluctuations. (2 brief recessions)

g) BUT: Weak American Agriculture: low prices, high debt, weak banks

h) BUT: Weak Europe: reparations, debts to U.S., slow growth, gold standard fragile (overvalued £, UK slumps) and (undervalued FF, France booms)

i) BUT: U.S. Stock market boom halts foreign loans to Germany, Eastern Europe and Latin America

Understanding the Great Depression: Its Evolution by Phases

2. Beginning Shocks, 1928-1929a) Spring 1927 U.S. expansionary monetary policy to ease pressure on the

British balance of payments. Critics assert policy too easy, and allows stock market boom to ignite

b) Fed tightens policy in 1928 (discount rate 3 ½ to 5%, and there is little increase in total money or credit for 1928-1929.

c) U.S. stock market boom begins March 1928. d) Commercial paper market vanishese) No new lending to Germany, Austria and rest of work in 1928….Germany

slides into a recession.f) Fed tries to “jaw-bone” market down. Criticizes brokers loans.g) July 1929 raises discount rate from 5 to 6%.h) But July-August is peak of business cycle. Recession begins Summer 1929i) October 1929 U.S. Stock market crash: wealth effect—lowers consumption

and investment, credit effect—reduces value of collateral and hence lendingj) Smoot-Hawley tariff 1929 by U.S. induces retaliatory tariffs by other countries,

international trade declines

Understanding the Great Depression: Its Evolution by Phases

3. Aggravating Shocks, 1930-1933a) Banking Panics, 1930, 1931, 1933b) Failure of the Fed to Pursue Expansionary Policyc) Collapse of Gold Standard: Austria, Germany leave the gold

standard, Britain departs after a run on the pound in September 1931d) U.S. begins losing gold, trade deficits and capital flight.

4. From Rock Bottom to Recovery, 1933-1936a) Bank Holiday March 1933b) U.S. abandons the Gold Standard March 1933c) New Deal Banking and Securities Legislationd) Monetary Expansione) Minimal Fiscal Policyf) National Industrial Recovery Act (NIRA)

5. The 1937-1938 Recessiona) The Fed Raises Reserve Requirements

6. The Recovery, 1939-1941a) Monetary Expansionb) Fiscal Expansion in preparation for war.

Four Basic Questions:1. Why It Began?

2. Why So Deep and 3. So Long?

• Friedman and Schwartz (and others), the economy is entering a recession in late 1929

• The economy is beginning to recover in 1931 like a normal business cycle

• BUT what makes the recession worse?• What turns the recession into a

depression?

The Worsening Depression• Slight recovery early 1931,then plunge.• Why?• Romer (1993) “The source of the continued

decline in production in the United States was almost surely a series of banking panics.”

• Friedman and Schwartz (1963) document four panics– Fall of 1930– Spring 1931– Fall 1931---Britain abandons the Gold Standard– First Quarter 1933

• 9000 Banks suspend operations. Depositors and stockholders lose $2.5 billion = 2.4% of GDP…...not the whole story

Why are there banking panics?

Why Banking Panics?• There were no banking panics in Canada.• Fragmented unit banking system• Undiversified bank portfolios with high

regional concentration of loans. Large number of bank closures in the agricultural states when agricultural prices fall. In addition, many hold bonds whose value collapsed.

• Many banks become insolvent• Fear of insolvency feeds the liquidity

crisespanics.

Effects of Banking Panics• Money Supply Declines and there is a massive

rise in realized real interest rates, over 10%.• Friedman and Schwartz blame inaction of the

Fed for this decline---and hence for the depression.

How do Friedman and Schwartz explain why the Fed did not act?

• Up to end of 1930– What is the Fed concerned

about?– How does it react to banking

failures?• Who was Benjamin Strong?• New York Fed v. Board of

Governors?• What could the Fed have

done 1930-1931?• What does Congress do?

Why didn’t the Fed act?• Beginning in 1931, Friedman and Schwartz argue that Fed

could have expanded but chose not to.• In diary of Charles S. Hamlin member of the FR Board, he

wrote during August 1931 that Open market committee voted 11 to 1 against $300 million open market purchase of bonds---reduce it to $120 million.

• Governor Mayer of the Board worried about inflation. • Members of the regional banks did not grasp the extent of

the crisis.• Pressure from Congress---open market operations of $1

billion. Until Congress adjourns.• After Britain leaves gold in September 1931, gold drain

starts. Dollars exchanged for gold---Fed’s reserves fall, it is afraid that further expansion will lead to greater loss of gold----constrained by the gold standard. Reserves falling after UK goes off gold in 1931, must retain high interest rates.

Understanding the Great Depression:Four Basic Questions

1. Why it Began?2. Why so Deep?3. Duration?4. Recovery?

Understanding the Great Depression:Four Basic Questions

1. Why it Began?Business Cycle Peak 7/8-1929, Federal Reserve’s tight policy

2. Why so Deep?Banking Panics. Inaction of the Federal Reserve

3. Duration?4. Recovery?

How is the economy driven into a severe depression by the declining

money supply?

What is the mechanism of transmission?

Several Explanations……

Romer (1993) basic argument is simple• Depression is the result of a series of aggregate demand

(monetary) shocks that moved economy down an upward sloping aggregate supply curve.

Output Output

Price Level

Price Level

Romer (1993) basic argument is simple• Depression is the result of a series of aggregate

demand (monetary) shocks that moved economy down an upward sloping aggregate supply curve.

• Result is two problems: (1) unemployment and (2) deflation.

• Unemployment: – Key point is the upward sloping supply curve. Wages

and prices not perfectly flexible in 1920s and 1930s.– Why did they become less flexible? Some studies

point to turn-of-the-century change in labor contracts, World War I or desire of business to keep demand strong.

– Wage and price stickiness means that aggregate demand shocks will have real effects.

The Sticky Wage Conundrum---markets don’t seem to clear

How did deflationary shocks affect the economy?

• Conventional 19th century view: fall in wages and prices raises stimulate investment, countering shock….but not in sticky price world.

• How did the monetary shocks hurt the economy?– Explanation 1: High real interest rate hypothesis:

Deflation affects expectations. Deflation generates expectations of higher real rate of interest, raising real rates and driving down investment

– Explanation 2: Debt-Deflation hypothesis: Unanticipated inflation increased real debt, increasing defaults and thus depressing supply of credit

Rising Real Interest Rates—Did the Fed

understand?• Nominal commercial paper

rate 1927.4 to 1928.4 rises from 4.0% to 5.5% and the realized real rate from 5.6% to 9.5%.

• Rational expectations estimates by Romer of the expected real interest rate are shown to rise----implying higher anticipated interest rates.

• Interest sensitive industries begin to slow in 1929: building permits and automobile registrations.

r = i – p(expected)

• Sources of the onset—1929-1930/1931 contrasts previous experience

• The decline in consumer spending and fixed investment that are the key elements that need to be explained.

Romer (1992)

The Risk Premium during the

Depression

Rate Romer uses

Debt Deflation Hypothesis: Hamilton looks at the futures markets for predictions of future prices----errors random until 1930s when underestimate deflation seriously----don’t believe that crisis will continue

Klug, Landon-Lane and White looked at the forecasts of Railroad Shippers and found huge cumulating errors in

forecasts of carloadings---businessmen keep thinking that

recovery is around the bend.

1928 1930 1932 1934 1936 1938 1940-50

-40

-30

-20

-10

0

10

20

Year and Quarter

perc

enta

ge e

rror

Bernanke’s Contribution—a Third Factor• In addition to monetary collapse, there was a

disruption of intermediation.• Bernanke (1983): banks play special role for

firms that cannot issue bonds and stocks. When banks fail the information and relationships are lost and the cost of credit intermediation rises. Costs include screening, monitoring, and accounting costs as well as expected losses from bad borrowers.

• Major contribution to economic decline 1931 and 1932.

Banking crises an important determinant of loans as much as industrial production.

Liquidation of loans after stock market crash

But then credit declines little even though IP falls 25% until banking crises.

Panic begins

Understanding the Great Depression:Four Basic Questions

1. Why it Began?Business Cycle Peak 7/8-1929, Federal Reserve’s tight policy

2. Why so Deep?Banking Panics. Inaction of the Federal Reserve—prolonged monetary contraction

3. Duration?----Clearly inaction plays a role—what else?

4. Recovery?

What about Fiscal Policy—Deficit Spending?

Output Output

Price Level

Price Level

Fiscal Policy?—Deficit Spending?Federal Deficit as Percentage of GDP

-10

-8

-6

-4

-2

0

2

4

6

8

10

1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939Per

cent

Actual GDP Full Employment GDP

In 2005---it was -2.6%

Industrial Policy?• Specific Intervention in industry?• National Industry Recovery Act (NIRA) of 1933

created the National Recovery Administration (NRA). (Declared unconstitutional May 1935)

• National Labor Relations Act (1935) that promoted unions and Fair Labor Standards Act (1938) that set minimum wages in certain industries and regulates working conditions.

• NRA established guidelines that raised nominal wages and prices and encouraged higher levels of employment by work-sharing reductions in the length of the work week.

Industrial Policy• Weinstein (1980), using

aggregate monthly data on hourly earnings in manufacturing, he found that the NIRA raised nominal wages directly and indirectly by raising prices. Econometric estimates that average hourly earnings would have been 35 cents not 60 cents.

• Result----higher wages create more unemployment and increase the duration of the depression because of higher costs to producers---counterproductive

• Shift in the Aggregate Supply Curve

Did the Duration have something to do with bad monetary policy?

After 1929-1933, had the Fed learned its lesson?

Recession of 1937-1938

• Did the Fed learn its lesson?• Rising excess reserves held by banks—

Fed worries about inflation potential and wants to induce lending.

• Uses new tool of required reserves. Required reserve ratio doubled.

• Result? Banks raise their excess reserves and huge monetary contraction.

Understanding the Great Depression:Four Basic Questions

1. Why it Began?Business Cycle Peak 7/8-1929, Federal Reserve’s tight policy

2. Why so Deep?Banking Panics. Inaction of the Federal Reserve. Prolonged Monetary Contraction

3. Duration?Continued Monetary Policy Mistakes, Fiscal Policy not tried. Industrial Policy makes things worse.

4. Recovery? Why?

Recovery, 1934-1937….why?• Real GDP grows at

10% p.a. 1934-1937.

• But real GDP on reaches 1929 peak in 1937 and trend path in 1942.

• What drove the recovery.

• Friedman and Schwartz (1963) and Romer (1992): huge increases in the money supply.

Real GDP, 1920-1941

60

70

80

90

100

110

120

130

140

1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941

1929

=100

What Increase

d the Money

Supply?

How was the money supply increased?• F.D. Roosevelt takes emergency powers granted by

Congress in the 100 days.• FDR allows the dollar to depreciate—sets new value for

gold in 1934: from $20.36 per ounce to $35 per ounce.• Huge revaluation of big U.S. gold stocks. Treasury issues

gold certificates equal in value to increase and deposits them with the Fed. As government spends them, they enter the monetary base. High powered money increased 12% between April 1933 and April 1934.

• Devaluation also improved the competitiveness of U.S. goods—rise in the trade balance.

• Devaluation attracted capital flows from Europe, especially with Hitler’s rise to power. High powered money rises 40% from April 1934 to April 1937.

• Result: real interest rates fall and recovery of investment and consumer durable spending.

What drove the money supply?

Understanding the Great Depression:Four Basic Questions

1. Why it Began?Business Cycle Peak 7/8-1929, Federal Reserve’s tight policy

2. Why so Deep?Banking Panics. Inaction of the Federal ReserveProlonged Monetary Contraction.

3. Duration?Continued Monetary Policy Mistakes, Fiscal Policy not tried. Industrial Policy makes things worse.

4. Recovery? Monetary Expansion

Some Effects of the Great Depression

1. Activist Monetary Policy2. Activist Fiscal Policy---idea of cyclically

balanced budget3. Insurance and Regulation of the Financial

Sector4. Agricultural Regulation5. Growth of Government and shift in Federalism6. Growth of Unions7. Genesis of Social Security8. Smoot-Hawley Tariff of 1929 to the WTO9. The IMF and World Bank